A new banking crisis round the corner?

Alasdair Macleod – 3 October 2009
In the last two weeks I have commented on the subject of contracting bank lending. Bank lending is beginning to contract despite central banks’ efforts to increase the amount of cash and credit in circulation. The root cause is zero deposit rates: negligible interest does not attract savings. Think Japan. Instead, cash is paying down debt or going into a rebounding stock market, where yields of two or three per cent are generous by comparison.

The banks are now faced with falling customer deposits, and customers paying back loans. Banks themselves are also reducing loan exposure where possible. This is understandable and prudent, but this contraction is beginning to develop a momentum of its own, with the rate of contraction showing signs of accelerating. Central banks are failing to encourage lending with their monetary policies, and commercial banks are leaving excess money on deposit with them. There are stories that the Bank of England and the Fed are likely to penalise these deposits, as the Swedish Riksbank is doing. But that will merely move these deposits somewhere else such as short-term government bonds, and not into consumer and corporate loans. Remember that the banks will try to maintain a balance between deposits and lending.

So far, the problem is only recognised as serious by very few. However, contracting bank credit creates its own crisis. Starved of new loans, increasing numbers of bank customers will default, adding impetus to the banks’ caution.

That the ordure has not yet hit the fan is entirely due to the rally in sentiment, reflected in stock and corporate debt markets. House prices have recovered a little, taking the immediate pressure off indebted consumers and mortgage-backed securities. There is a feeling that the worst is now behind us. But the rallies in asset prices and sentiment are now loosing momentum, with mortgage backed securities drifting off 10% in the last few days and stock markets flagging. The feel-good factor may begin to fade, leaving us with the naked reality of contracting bank lending.

It is now possible that contracting bank lending will fuel a decline in sentiment, once the decline starts in earnest. If this happens it will only be a matter of time before we find ourselves slipping towards a second banking crisis. Could it be like the Credit Anstalt crisis in May 1931, when the Austrian bank’s collapse spread throughout central Europe, and caused a second global financial melt-down after 1929?

However and wherever it starts, a second banking crisis will be virtually impossible to stop. Banks are counterparties to each other in wholesale markets and derivatives. We saw the powerful effect of the former in the credit crunch two years ago when wholesale markets seized up. The dangers posed by derivatives have yet to be exposed.

According to the Federal Deposit Insurance Corporation, the derivative exposure of US commercial banks at end-June amounted to $205 trillion, almost all of which is in the hands of the 533 commercial banks with balance sheet assets of more than $1bn. This figure has actually increased by $31 trillion since the Credit Crunch, when Buffet, Soros and Moulton were warning of the dangers derivatives posed. So instead of heading these warnings, banks have ignored them and continued to inflate the derivative bubble. (As a reality check, note that US GDP is currently about $14.5 trillion)

The FDIC’s balance sheet totals do not incorporate gross derivative exposure, which is shown as a memorandum item. This exposure is 19.25 times the sum of the balance sheet totals of the 533 larger banks. Equity in these banks, less goodwill, is a paltry $732bn, so the true gearing on this equity base including gross derivative exposure is 205/0.732 = 280 times equity! So we can see that a mouse-fart in the derivative market could set off a chain of financial destruction.

It was this knowledge that forced the authorities to rescue Bear Sterns and AIG, both of which are major derivative counterparties.

The bulk of the derivative exposure ($170 trillion) is in interest rate contracts, mostly swaps. These are unlisted contracts – as they all are – where a bank has direct exposure to one or more other banks. The vast majority of these contracts spawn other contracts, because exposure is often hedged by these means. There is no market to guarantee delivery. This huge market nets down to not much, perhaps a few tens of trillions, but the point is the net value is the very small tip of a very big gross amount.

If a small bank goes under, its derivative defaults can usually be managed by the FDIC. So far, the FDIC has not been tested much, because the smaller US banks that have collapsed so far had very little exposure to derivatives. But if a banking crisis develops in Europe, it rapidly becomes an unmanageable problem in New York, London and Tokyo. It also becomes a big problem for hedge funds, insurance companies, and those entities already owned by governments as a result of the last round of bank rescues.

Questions arise, even if we could wave a magic wand and somehow handle a banking crisis with whatever international co-operation it takes. Have central banks and governments the monetary resources required? Remember, the Fed has already blown about $12 trillion in actual support and guarantees in Round 1 of the banking crisis. Remember also that this is nearly one year’s worth of US GDP. How will the Fed respond when that big poker player in the sky raises the anti and calls the governments’ bluff in Round 2? How will Iceland fare, how will Ireland, and Austria, and Switzerland, all of which face guaranteeing bank exposure many multiples of their GDP?

Doubtless, if this derivative bubble unravels, regulators will be blamed for allowing banks to continue to inflate the derivative bubble since the credit crunch. Of course they should have done something about it; but in this case we can definitely blame the large banks who should have learned the importance of counterparty risk. Instead the bankers have learned the Fed will never allow them to fail, so they can continue to wheel and deal in derivatives with impunity.

Perhaps what makes this most likely to happen is that very few people now expect it to.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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